Updated: May 1
This Wall Street Journal headline suggests:
"Nonbank Lenders Are Dominating the Mortgage Market - Nonbanks issued more than two-thirds of mortgages in 2020, their highest market share on record"
- McCaffrey, 2021 - Wall Street Journal
Since then, Wells Fargo, traditionally one of the nation's largest mortgage lenders has made the decision to dramatically reduce its mortgage market footprint. This is a continuation of the trend for many banks to pull out of mortgage and other consumer loan products.
"Wells Fargo Is Backing Out Of The Mortgage Market"
- Q.ai, 2023 - Forbes
Article introduction: First, systemic risk is defined. Then, we show the paradox - that in the zeal to reduce the banking industry's systemic risk, an unintended consequence is a potential for a less resilient financial services system.
For systemic risk in the context of a bank failure, please see our article:
What Is Systemic Risk?
Systemic risk is the possibility that an event at the company level could trigger severe instability or contribute to the collapse of an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are called "too big to fail."
Traditionally, these institutions are large relative to their respective industries or make up a significant part of the overall economy. Increasingly, the degree of industry connectivity and impact is an important source of systemic risk. Size alone is not the only determinant of systemic risk.
Following the financial crisis, regulators and lawmakers made changes to reduce systemic risk in the banking industry. This article discusses the paradox - that in the zeal to reduce the banking industry's systemic risk, an unintended consequence is the potential for a less resilient financial services system. A less resilient system may increase the systemic risk impact of individual participants. We will start by discussing some of the drivers of systemic risk via attendant financial risks. We then discuss how this paradox exists as a result of reducing the impact of the banking industry as a part of the overall financial system.
How financial risk becomes a systemic risk
There are differences between held-to-maturity ("HTM") and available-for-sale ("AFS") accounting when it comes to bank uses like securities or loans. By rule, the bank must decide when the security or loan is booked whether to designate it as HTM or AFS. This is critical. It is challenging to change after the fact without taking a large impairment. There is a volume of accounting rules governing the HTM and AFS nuances. [i]
Based on an intuitive understanding of accounting rules, the HTM portfolio is not generally required to be marked to market. That means asset values can go up or down with the market. However, the intrinsic value as found in the bank's financial statements is based on the income produced by the stated yield of the bond or loan. Conceptually, a bank can "ride out" price fluctuations if its securities or loans are booked as HTM assets. It also helps if the bank holds Residential Mortgage Backed Securities. "RMBS" present no credit risk as they are backed by Fannie Mae, Freddie Mac, and the U.S. government. In the post-financial crisis world, RMBS is the Fed's go-to security to implement quantitative easing. "QE" is how the Fed manages the money supply and interest rates at the long end of the yield curve. This monetary policy tool has been used in lower-rate environments since the financial crisis.
The Systemic Risk Paradox
AFS is a different animal and creates more exposure to market volatility because AFS securities and loans are regularly marked to market.
An AFS example is Mortgage Servicing Rights (“MSRs”). A mortgage is split into 2 pieces, the RMBS which we discussed earlier, and the MSR. Both are tradeable securities.
Think of the RMBS as the deep-pocket investor that owns your mortgage and receives the payment.
Think of the MSR as owned by the company that services your mortgage and collects your payments on behalf of the investor.
Importantly, the RMBS owner and the MSR owner are usually NOT the same company.
MSRs are held as AFS by the mortgage servicer. Mortgage servicers buy and sell MSRs all the time. So booking them as AFS makes sense. MSR values are extremely volatile and must be marked to market quarterly. It creates a challenge for the mortgage servicer’s CFO team. MSRs are notoriously difficult to manage and hedge. They often create significant volatility in the mortgage servicer’s earnings. As interest rates go down, MSR values go down. Conversely, as interest rates move up, MSR values move up. Before the financial crisis, banks held loans, RMBS, and MSRs. When rates go up, the MSRs acted as a natural hedge against the margin compression. Now that banks have mostly retreated from the mortgage servicing business, that natural hedge has evaporated.
The great unintended consequence
Overweighting prescriptive-based regulation and underweighting principles-based regulation
Creates regulatory incentives to flee banking
It is interesting how the regulatory environment has evolved since the financial crisis. Today’s post-financial crisis "prescriptive-based regulation" environment creates incentives for non-bank mortgage servicing companies to own the MSRs. As a group average, non-banks are significantly lower capitalized than their bank cousins. It is a head-scratcher that our financial system creates incentives to transfer risk from higher capitalized, higher earnings quality banks to lower capitalized, lower earnings quality non-banks. Also, those riskier MSRs could help banks hedge against today's rapidly increasing rate environment. Instead of managing systemic risk in total, it seems we may be creating more total systemic risk by redefining banking more narrowly. In the case of bank and non-bank interactions -- All we have done is move money (higher risk AFS) from one pocket (bank) to another (non-bank), but the new pocket (non-bank) is more likely to have holes! (less capital/potential for more systemic risk impact)
In the context of the Silicon Valley Bank failure, SVB loaded up with mortgage securities. In the past when banks made mortgage loans to customers, they were more likely to hold both the loan asset and the servicing asset (MSR). In a rising rate environment, the MSR acts as a natural hedge, the value of the MSR increases while the loan asset decreases in value. That natural hedge is now gone for many banks. This has created increased earnings volatility and as in the case of SVB, much greater bank failure risk.
This financial system's reality may sow the seeds for the next crisis!
Prescriptive-based v Principles-based regulation: A football analogy
Soccer - otherwise known as Football - is an example of a principles-based regulatory environment. The soccer rule book is only a few pages long. There are only 17 Laws Of The Game, according to the governing body, FIFA. The enforcement of the laws is done by a single-game referee (center ref). The referees are trained on the laws and are expected to enforce the laws during soccer games. It is the center ref that has some flexibility to properly evaluate each game situation as to rule enforcement. A video review has recently been included for certain games. Also, there are two assistant referees and a 4th official. Soccer is meant to flow and rarely stop. The game stops briefly to reset play for fouls and half-time. Soccer uses a running clock.
Football - otherwise known as American Football - is an example of a prescriptive-based regulatory environment. The NFL (American Football professional sports league) has a 243-page dense rule book. The word count in the NFL rule book is over 196,000 words. Every game has 7 field officials, video review officials, and referee support personnel. American football is very choppy. It has regular breaks in action for downs, team time-outs, video reviews, quarters, and TV time-outs. American football uses a stopping clock.
Perhaps the soccer approach to regulating the game has some application to banking. Perhaps it is time to swing the regulatory enforcement balance back toward a principles-based approach. Life - including the business and banking environment - flows. Banks have to run their businesses in real time. At best, regulators only get to criticize banks after the fact. Rarely does one get a choppy stoppage of play to make regular rule decisions and rule enforcement adjustments in real-time. In the extreme, the current prescriptive-based approach runs the risk of only regulating the risks of the past -- and, by doing so, enables the systemic risks of the future.
[i] See the google search "accounting rules afs and htm." There are over 600,00 entries. I suggest a source from an accounting firm or the SEC.